Sustainable Economic Recovery and the Future of the Russian Reform
Dr Vladimir Tikhomirov
During the past decade Russia had went through a series of dramatic changes that had a profound effect on the way its economy operated, was managed and funded. The aim of this paper is to analyse new developments that had taken place in funding of the Russian national economy and the effect these changes had and might have in the future on the overall economic performance of the country.
In the last two years, for the first time since the mid-1980s, Russia was registering a continuing economic growth. This was a major change to the previous period and it prompted many observers to state that the Russian economic decline was finally over and that the country was now steadily moving along the road to recovery. By late 2000, however, this upbeat mood has given way to more gloomy forecasts of the future Russian economic growth, when a number of prominent Russian economists warned that Russia's economy was heading towards a recession.
At the time of writing it is still too early to give any definite conclusion as to whether the Russian economy is now heading for a recession or for a temporary slowdown in the tempo of its growth. Nevertheless, no matter what the immediate future might hold for Russia some of its fundamental economic indicators, like investment trends, point to the fact that the past two years have not seen any major changes in the predominantly negative strategic economic tendencies that crippled the Russian economy during the last one and a half decades.
One of the main features of the Russian economic reform was a rapid decrease in the state involvement in the national economy. A significant share of state property was privatised, while expenditure on national economy from the consolidated state budget had dropped from 54.5% in 1985 to just 17.3% in the first half of 2000.
In other words, one might say that during the 1990s the state had ceased to be a dominating factor in funding of the Russian economic growth. But before we can confirm this conclusion let us look at the dynamics of capital investment in the Russian economy. In my earlier publications I have stressed that analysis of capital investment trends provides us with the best indicator of the future growth prospects of the Russian economy. Moreover, major part of this investment has a long-term nature and is rather difficult to be converted into cash, in case circumstances in the future change dramatically for the worst. Also, for majority of Russian enterprises and branches of the national economy capital investment is the most essential prerequisite on the way towards a far-reaching restructuring of the grossly imbalanced and over-monopolised economic structure that Russia had inherited from the Soviet era. Thus, an analysis of capital investment trend can provide us with a rather clear indication of how Russian and foreign investors assess the future prospects of political and economic development of the country, attractiveness of its current and restructured economic potential (particularly if measured against the risks they will have to take today), as well as the effectiveness of the current Russian economic planning and management.
General dynamics of investment trend in the Russian economy show that during the past decade the volumes of capital investment in constant prices have experienced a far larger decline than Russia's GDP. By September 2000 capital investment in Russia was equal to just 24.6% of the amount invested in the still state-controlled Soviet economy of Russia in 1990. Between 1990 and 1999 the share of direct public funding of the investment needs in the economy has fallen from over 90% to 26%. However, the share of budgetary funding declined far less significantly: in 1990 the total share of budgetary funding stood at 37.2% and in January-September 2000 it was 26.1%. In fact, throughout the reform period and up until now the share of state funding for the economy has been consistently larger than that of direct private funding, which was a clear reflection of the uncompleted and frequently rather chaotic character of the Russian political and economic reform process.
According to the official data series published by the Russian Statistical Committee (Goskomstat) the largest part of capital investment in Russia was coming from investment made by companies and firms themselves. This share, however, often includes credits and loans that these enterprises have taken from outside creditors, other companies or from the state. The intensification of crisis tendencies in the Russian economy in the second half of the 1990s had led to shrinking of capabilities of the majority of enterprises to fund their own investment needs. In 1994 three-quarters of capital investment in Russia came from various credits; by September 2000 the share of credits was already at 97.4%.
While the role of crediting in Russian investment was increasing, the major part of these credits was not issued by crediting organisations (banks, finance companies, etc.). This can serve as yet another indicator of the general underdevelopment of market infrastructure and services in Russia. Bank credits made up only 3.3% of all capital investment in January-September 2000 which was 2.5 times lower than the share of credits issued by other enterprises and companies. Also, issues of company shares have failed to gain the importance they have in the West as a source of investment: between 1995 and 2000 sales of new shares have funded less than 1% of the gross capital investment.
So where does the major part of capital investment come from? Although Russian statistics make it rather hard to give a definite answer to this question, it seems that the largest share of funds for capital investment needs is still continuing to come from a variety of federal and local state sources (budgets, funds, loans and subsidies). The next important source is inter-enterprise credits, loans and subsidies. Due to the fact that the overwhelming majority of large profitable companies in Russia (the ones that can give this sort of credits) are still either fully or partly in the hands of the state, one might say that the proportion of public funding in capital investment in Russia is probably significantly higher than it is officially recognised. A large part of what is considered as "private" funding of capital investment also comes mainly in the form of inter-enterprise credits, with only a small proportion coming from banks and other credit institutions. The last important source of investment is funds that are provided by enterprises themselves. It needs mentioning in this regard that issues of shares play a far less important role in capital accumulation than the funds that an enterprise was able to save from the revenues it received or even from underpaying its own staff.
Thus, despite its dramatically decreased involvement, public finance continues to play a dominant role in the promotion of capital investment in Russia. While this conclusion might seem to be in a contradiction with the objective that was proclaimed by Russian reformists in the early 1990s who sought to see the state (totally) disengage from the management and funding of the national economy, the post-Soviet economic reality turned out to be somewhat different from these envisaged aims. Throughout the 1990s a widespread economic crisis had financially crippled most of Russian enterprises, while rapid and not necessarily thought-through fiscal and price reforms and privatisation have made the situation even more dire for a substantial number of companies. Indeed, the volume of state funding of the economic development was continuously falling in the 1990s, but these falls were not compensated by relevant increases in private funding as initially was hoped. What happened was that the dynamics of capital investment in Russia were largely following the negative trend in public funding for the national economy. For instance, while in 1990-1999 capital investment from all sources in constant prices had fallen by almost 78%, during the same period the gross expenditure on national economy from the consolidated state budget in real terms had decreased by a smaller amount of 73%.
During the first ten months of 2000 the gross volume of capital investment had increased by almost 20% compared to the same period of the previous year. Although this was an impressive and promising increase, in overall terms investment levels remain to be far below the needs of the Russian economy.
Another important indicator in investment area is the structure of capital investment. This indicator can help us to define whether this investment, even as small as it is, is able to have a strategic effect on the restructuring of the Russian economy. During the 1990s the most important changes in the structure of capital investment were a dramatic decline in the volumes of capital invested in agriculture and an impressive increase in the share of funds directed towards investment in transport and communications. In real terms by September 2000 the volume of capital investment in agriculture was equal to just 4.1% of its 1990 level while that of transport and communications stood at almost 52%. The share of industry in the total volume of capital investment had also increased, particularly during the last two years.
During January-September 2000 the two most important areas, which accounted for more than two-thirds of all capital invested into the Russian economy, were fuel industry and transport. This was a direct reflection of the dominating role played by the fuel industry in the production of Russia's GDP as well as of the territorial vastness of Russia; the latter making development of transport a crucial factor in the economic stability and political unity of the country. The other areas with significant shares were housing and communal services (15.7% of the total), electricity production (4.3%), machine-building and non-ferrous metallurgy (3.2% each).
The above analysis of capital investment trends in the Russian Federation shows that since the Soviet economic system collapsed there were no principal changes in the way Russian economy was funded. While in formal terms much of the economy now is in private hands and the state no longer plays a leading role in economic management, most of strategic funding for the economy continues to come from a variety of public sources. At the same time the volume of financial resources controlled by the state had significantly reduced, which led to a dramatic decline in the amount of funds provided for investment. The latter also explains why Russia so far failed to implement any viable long-term investment strategies aimed at restructuring of its economic potential, creation of new jobs and raising of the efficiency of its enterprises. Instead, distribution of investment funding was carried out in Russia mostly on an ad hoc basis and was dominated more by political influences, levels of access to public funds and controls over profitable companies and industries, rather than by any national economic policy.
Therefore, it comes as no surprise that the lion share of capital investment in Russia was absorbed by its major export industries (fuel and gas) which were capable of generating revenues, and by predominantly state-controlled utilities and communal public services. The need to maintain, repair and update the crumbling Soviet infrastructure became especially apparent by the late 1990s, when Russia started to experience an alarming rise in the incidents of so-called technological catastrophes. At the same time, most of other industries, services and branches of the national economy were continually suffering from gross lack of finance, which meant that the issues of restructuring of the economy and outsourcing of its investment funding still remained unsolved.
Another illusion that was shared by the majority of Russian reformists in the early 1990s was that opening up of the Russian economy would almost automatically lead to a flow of large foreign investment into the Russian market. Thus it was hoped that any cuts to public funding of the economy (including investment) could be easily compensated by increases in the levels of capital invested by private local and foreign businesses. The reality, however, turned out to be different. By 1999 'pure' private investment was still below amounts of capital invested from public sources, while the share of capital investment made by foreigners during the larger part of the 1990s was around 2%.
According to Goskomstat, by 1 October 2000 the total volume of accumulated foreign investment in the Russian economy was US$32 billion. In January-September 2000 foreign direct investment (FDI) comprised 40% of the total foreign investment in the Russian economy or about US$3.2 billion. During the same period sectors with the largest shares of FDI included trade and catering, transport, food processing and fuel industry. In the structure of foreign investment from all sources, excluding financial operations stock market operations, most attractive areas were industry (particularly food processing) and trade and catering. During 1996-1997, when the Russian bond market was rapidly expanding, areas of credit and finance absorbed over half of all foreign investment. In October 2000 countries with the largest shares in the gross accumulated foreign investment in Russia were USA, Germany, France, UK and Cyprus.
In general, neither local private investment nor foreign investment managed to fill in the gap in capital investment that appeared as a result of huge reductions in public funding. The latter was often attributed to fiscal decentralisation and the dramatic reduction in state property as a result of privatisation. Yet another reason for cuts in state investment, that is often cited by Russian officials, is the need to make large repayments on Russia's sovereign debt. In this regard it is important to mention that up until 1998 the total amount of de facto debt payments made from the Russian state budget was quite manageable and did not exceed 6.9%. However, starting from 1998 the share of debt repayments increased to almost 18% and is set to increase even further in the next 3-5 years.
There is little doubt that the problem of debt repayments will significantly hamper prospects for implementation of an active investment policy in the future. Capital investment trend was constantly going down even during the 1990s when the budgetary share of debt repayments was relatively low and when Russia was quite successful in securing large foreign credits. Substantial increases in debt repayments that are projected for next few years are likely to force Russians to postpone even further plans for economic restructuring. Economic growth that Russia enjoyed in 1999-2000 is not likely to provide enough resources for any significant increase in the investment funding.
When in 1998 the Russian government was faced with the need to find resources for large debt repayments, as a way of increasing revenues to the state budget it once again chose to use fiscal levers that it still had under its control rather than to embark on a difficult road of implementation of a restructuring strategy. Back in October 1998 the Russian Central Bank (RCB) had introduced mandatory sales of foreign currency requiring the sale of 75% of export earnings of Russian exporters. This, together with a tightly controlled process of the devaluation of the national currency, rouble, against major foreign currencies had allowed RCB and the government to accumulate significant reserves of foreign currency. Between January 1999 and January 2001 total currency and gold reserves of RCB and the Russian Ministry of Finance increased by an impressive 2.3 times and reached US$ 28 billion. At the same time Russian rouble and population incomes (in dollar equivalent) were kept devaluated by 2-2.5 times from their peak mid-1990s levels. This meant that the Russian government and RCB were able, for the first time since 1990, to balance the state budget. In fact, during 2000 budgetary expenditures were continuously lower than revenues.
In addition to the new fiscal and currency policies of the RCB, another factor that played a crucial role in bringing about the current financial stabilisation in Russia were recent developments in world energy markets. In 1999-2000 the rise of world prices for crude oil had brought significant additional flows of hard currency to the Russian state currency reserves. Between 1998 and the first nine months of 2000 export earnings from the sale of crude oil had increased by more than 1.4 times, while physical volumes of oil exports had actually fallen by almost 20%. This allowed Russia to reap additional revenues without any large increases in its oil production and, consequently, without the need to make any large-scale investment in the sector. The rise of prices for energy products had also led to their increased share in the total Russian exports: in January-September 2000 this share was equal to over 52% of the total exports in US dollar terms.
The other important recent development in the area of foreign trade was a rapid decline in the volumes of Russian imports in the period that followed the 1998 financial crisis. Thus, in 1998 total Russian imports have fallen from their peak level in 1997 by 20%; in 1999 they have fallen by a further 30%. Although in January-September 2000 there was a slight increase recorded in the volumes of Russian imports (they were 9% higher than in the same period of 1999), overall on an annual basis imports remained at about 40% below their peak levels.
Such a dramatic change in the dynamics of Russian imports came as a combined result of new currency policies implemented by the RCB in the aftermath of the 1998 crisis, and accompanying large falls in the population income levels, expressed in US dollars. These two factors have almost immediately made the majority of imported goods too expensive for an average Russian consumer. In turn, the latter development opened doors into the market for the struggling Russian industry and agriculture, which started to fill in the gaps in the supply of consumer goods. The result was a substantial rise of production activity across the Russian economy in 1999-2000.
Despite of the encouraging growth signs and favourable for Russia situation on the world energy markets, there were no significant changes implemented in investment and overall economic strategies pursued by the Russian government. Majority of Russian industries continues to be grossly underfunded while their managers simply do not have resources for implementing any viable investment policies. Thus, many Russian companies continue to deplete their fixed capital assets, most of which date back to the Soviet period. At the same time the Russian state, as in the previous years, is mostly engaged in reaping off revenues of the more profitable enterprises, pressing the latter to hide and export any additional money they earn and manage to hide away from taxation authorities.
One of fundamental problems associated with the current investment crisis in Russia lies in the fact that despite a decade of market reform attempts Russia still does not have an efficient banking and crediting system. Failure to create such a system has led to a situation when the state was forced to continue to act as the main creditor and investor in the national economy, in an open contradiction to the initially proclaimed goals of reformists. In fact, contradictory and inconsistent policies pursued by Russian reformists during the 1990s to a large extent have hampered the development of a stable and strong banking system. For instance, during the first three years of the Russian reform the Russian financial authorities have allowed a rapid expansion of an inter-bank credit market, which in the year of its collapse (1995) absorbed over 35% of all credits issued by Russian banks. But it was only a few months after this collapse that the authorities themselves created a new attractive financial investment scheme that again diverted much-needed resources from the real economy. In 1996-1998 the Russian state bond market became most profitable area of investment in Russia. After a short rise in the late 1995, the share of long-term credits in the overall volume of credits issued to the Russian economy fell to less than 4% and stayed at this low level up until the collapse of the bond market in August 1998.
The August 1998 crisis had a severe negative effect on the majority of Russian banks. At the time of writing, two and a half years since the August 1998 collapse, Russian banking system is still yet to recover. Following the crisis the total volume of bank credits fell to about 10-13% from its 1997 pre-crisis level, despite the fact that in recent years the funding priorities of Russian bankers have clearly shifted towards preference to long-term crediting of industry. However, shares of capital investment and shares of bank credits in the gross volume of issued credits remained extremely low and continued to fall.
In conclusion, the following points should be made:
Dr Vladimir Tikhomirov
The University of Melbourne